The Role of Government

The public sector in every economy plays a major role, as a producer and employer. Governments
work locally, nationally and internationally. Here are the roles they play in the economy:

 As a producer, it provides, at all levels of government:

 merit goods (educational institutions, health services etc.)
 public goods (streetlights, parks etc.)
 welfare services (unemployment benefits, pensions, child benefits etc.)
 public services (police stations, fire stations, waste management etc.)
 infrastructure (roads, telecommunications, electricity etc.).
 As an employer, it provides at all levels of government, employment to a large population,
who work to provide the above-mentioned goods and services. It also creates employment by
contracting projects, such as building roads, to private firms.
 Support agriculture and other prime industries that need public support.
 Help vulnerable groups of people in society through redistributing income and welfare
schemes.
 Manage the macroeconomy in terms of prices, employment, growth, income redistribution
etc.
 Governments also manage its trade in goods and services with other countries by negotiating
international trade deals.

Government Macroeconomic Aims

The government’s major macroeconomic objectives are:

Economic Growth: economic growth refers to an increase in the gross domestic product
(GDP), the amount of goods and services produced in the economy, over a period of time.
More output means economic growth. But if output falls over time (economic recession), it
can cause:
 fall in employment, incomes and living standards of the people
 fall in the tax revenue the govt. collects from goods and services and incomes,
which will, in turn, lead to a cut in govt. spending
 fall in the revenues and profits of firms
 low investments, that is, people won’t invest in production as economic
conditions are poor and they will yield low profits.

Price Stability: inflation is the continuous rise in the average price levels in an economy
during a time period. Governments usually target an inflation rate it should maintain in a year,
say 3%. If prices rise too quickly it can negatively affect the economy because it:
 reduces people’s purchasing powers as people will be able to buy less with the
money they have now than before
 causes hardship for the poor
 increases business costs especially as workers will demand higher wages to
support their livelihood
 makes products more expensive than products of other countries with low
inflation. This will make exports less competitive in the international market.
 Full Employment: if there is a high level of unemployment in a country, the following may
happen:
 the total national output (goods produced) will fall
 government will have to give out welfare payments (unemployment benefits) to
the unemployed, increasing public expenditure while income taxes fall – causing
a budget deficit
 large unemployment causes public unrest and anger towards the government.

Balance of Payments Stability: economies export (sell) many of their products to overseas
residents, receive income and investment from abroad, import (buy) goods and services from
other economies, and make investments in other countries. These are recorded in a country’s
Balance of Payments (BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
All economies try to balance this inflow and outflow of international trade and payments and
try to avoid any deficits because:
 if it exports too little and imports too much, the economy may run out of foreign
currency to buy further imports
 a BoP deficit causes the value of its currency to fall against other foreign
currencies and make imports more expensive to buy, while a BoP surplus causes
its currency to rise against other foreign currencies and make its exports more
expensive in the international market.

Income Redistribution: to reduce the inequality of income among its citizens, the
government will redistribute incomes from the rich to the poor by imposing taxes on the rich
and using it to finance welfare schemes for the poor. All governments struggle with income
inequality and try to solve it because:
 widening inequality means higher levels of poverty
 poverty and hardship restricts the economy from reaching its maximum
productive capacity.

Conflict of Macroeconomic Aims

When a policy is introduced to achieve one macroeconomic aim, it tends to conflict with one or more
other aims. In other words, as one aim is achieved, another aim is undone. Let’s look at some conflicts
of government macroeconomic aims.

Full Employment v/s Price Stability

Low rates of unemployment will boost incomes of businesses and workers. This rise in incomes,
mean higher demand and consumption in the economy, which causes firms to raise their prices –
resulting in inflation. This is probably the most prominent policy conflict in the study of Economics.
Economic Growth & Full Employment v/s BoP Stability
Once again, as incomes rise due to economic growth and low unemployment, people will import more
foreign products and consume relatively less domestic products. This will cause a rise in imports
relative to exports and a deficit may arise in the balance of payments.
Economic Growth v/s Full Employment
In the long run, when economic growth is continuous, firms may start investing in more capital
(machinery/equipment). More capital-intensive production will make a lot of people unemployed
Fiscal Policies

Budget: a financial statement showing the forecasted government revenue and expenditure in the
coming fiscal year. It lays out the amount the government expects to receive as revenue in taxes and
other incomes and how and where it will use this revenue to finance its various spending endeavours.
Governments aim for its budgets to be balanced.

Government spending
Governments spend on all kinds of public goods and services, not just out of political and social
responsibility, but also out of economic responsibility. Government spending is a part of the aggregate
demand in the economy and influences its well-being. The main areas of government spending
includes defence and arms, road and transport, electricity, water, education, health, food stocks,
government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

 To supply goods and services that the private sector would fail to do, such as public goods,
including defence, roads and streetlights; merit goods, such as hospitals and schools;
and welfare payments and benefits, including unemployment and child benefits.
 To achieve supply-side improvements in the economy, such as spending on education and
training to improve labour productivity.
 To spend on policies to reduce negative externalities, such as pollution controls.
 To subsidise industries which may need financial support, and which is not available from
the private sector, usually agriculture and related industries.
 To help redistribute income and improve income inequality.
 To inject spending into the economy to aid economic growth.

Effects of government spending

 Increased government spending will lead to higher demand in the economy and thus aid
economic growth, but it can also lead to inflation if the increasing demand causes prices to
rise faster than output.
 Increased government spending on public goods and merit goods, especially in infrastructure,
can lead to increased productivity and growth in the long run.
 Increased government spending on welfare schemes and benefits will increase living
standards, and help reduce inequality.
 However too much government spending can also cause ‘crowding out’ of private sector
investments – private investments will reduce if the increase in government spending is
financed by increased taxes and borrowing (large government borrowing will drive up interest
rates and discourage private investment).
Tax

Governments earn revenue through interests on government bonds and loans, incomes from fines,
penalties, escheats, grants in aid, income from public property, dividends and profits on government
establishments, the printing of currency etc; but its major source of revenue comes from
taxation. Taxes are compulsory payments made to the government by all people in an economy.
There are many reasons for levying taxes on the economy:

 It is a source of government revenue: if the government has to spend on public goods and
services it needs money that is funded from the economy itself. People pay taxes knowing
that it is required to fund their collective welfare.
 To redistribute income: governments levy taxes from those who earn higher incomes and
have a lot of wealth. This is then used to fund welfare schemes for the poor.
 To reduce consumption and production of demerit goods: a much higher tax is levied on
demerit goods like alcohol and tobacco than other goods to drive up its prices and costs in
order to discourage its consumption and production. Such a tax on a specific good is
called excise duty.
 To protect home industries: taxes are also levied on foreign goods entering the domestic
market. This makes foreign goods relatively more expensive in the domestic market, enabling
domestic products to compete with them. Such a tax on foreign goods and services is
called customs duty.
 To manage the economy: as we will discuss shortly, taxation is also a tool for demand and
supply side management. Lowering taxes increase aggregate demand and supply in the
economy, thereby facilitating growth. Similarly, during high inflation, the government will
increase taxes to reduce demand and thus bring down prices. More on this below.

Classification of Taxes
Taxes can be classifies into direct or indirect and progressive, regressive or proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person or
individual responsible for paying it.
 Income tax: paid from an individual’s income. Disposable income is the income left after
deducting income tax from it. When income tax rise, there is little disposable income to spend
on goods and services, so firms will face lower demand and sales, and will cut production,
increasing unemployment. Lower income taxes will encourage more spending and thus higher
production.
 Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is increased,
businesses will have lower profits left over to put back into the business and will thus find it
hard to expand and produce more. It will also cause shareholders/owners to receive lower
dividends/returns for their investments. This will discourage people from investing in
businesses and economic growth could slow down. Reducing corporate tax will encourage
more production and investment.
 Capital gains tax: taxes on any profits or gains that arise from the sale of assets held for
more than a year.
 Inheritance tax: tax levied on inherited wealth.
 Property tax: tax levied on property/land.
Advantages:

 High revenue: as all people above a certain income level have to pay income taxes, the
revenue from this tax is very high.
 Can reduce inequalities in income and wealth: as they are progressive in nature – heavier
taxes on the rich than the poor- they help in reducing income inequality.

Disadvantages:

 Reduces work incentives: people may rather stay unemployed (and receive govt.
unemployment benefits) rather than be employed if it means they would have to pay a high
amount of tax. Those already employed may not work productively, since for any extra
income they make, the more tax they will have to pay.
 Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs to set up new
firms, as a good part of the profits they make will have to be given as tax.
 Tax evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus tax
revenue falls and the govt. has to use more resources to catch those who evade taxes.

Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods and services
and it is paid while purchasing the good or service. It is called indirect because it indirectly takes
money as tax from consumer expenditure. Some examples are:
 GST/VAT: these are included in the price of goods and services. Increasing these indirect
taxes will increase the prices of goods and services and reduce demand and in turn profits.
Reducing these taxes will increase demand.
 Customs duty: includes import and export tariffs on goods and services flowing between
countries. Increasing tariffs will reduce demand for the products.
 Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its demand.

Advantages:

 Cost-effective: the cost of collecting indirect taxes is low compared to collecting direct taxes.
 Expanded tax-base: directs taxes are paid by those who make a good income, but indirect
taxes are paid by all people (young, old, unemployed etc.) who consume goods and services,
so there is a larger tax base.
 Can achieve specific aims: for example, excise duty (tax on demerit goods) can discourage
the consumption of harmful goods; similarly, higher and lower taxes on particular products
can influence their consumption.
 Flexible: indirect tax rates are easier and quicker to alter/change than direct tax rates. Thus
their effects are immediate in an economy.

Disadvantages:

 Inflationary: The prices of products will increase when indirect taxes are added to it, causing
inflation.
 Regressive: since all people pay the same amount of money, irrespective of their income
levels, the tax will fall heavily on the poor than the rich as it takes more proportion of their
income.
 Tax evasion: high tariffs on imported goods or excise duty on demerit goods can encourage
illegal smuggling of the good.
Progressive Taxes are those taxes which burdens the rich more than the poor, in that the rate of
taxation increases as incomes increase. An income tax is the perfect example of progressive
taxation. The more income you earn, the more proportion of the income you have to pay in taxes, as
defined by income tax brackets.
For example, a person earning above $100,000 a month will have to pay a tax rate of 20%, while a
person earning above $200,000 a month will have to pay a tax rate of 25%.

Regressive Taxes are those taxes which burden the poor more than the rich, in that the rate of
taxation falls as incomes increase. An indirect tax like GST is an example of a regressive tax
because everyone has to pay the same tax when they are paying for the product, rich or poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns $500 dollars a month,
this tax will amount to 0.2% of his income, while for a richer person who earns $50,000 a month, this
tax will amount of just 0.002% of his income. The burden on the poor is higher than on the rich,
making its regressive.

Proportional Taxes are those taxes which burden the poor and rich equally, in that the rate of
taxation remains equal as incomes rise or fall. An example is corporate tax. All companies have to
pay the same proportion of their profits in tax.
For example, if the corporate tax is 30%, then whatever the profits of two companies, they both will
have to pay 30% of their profits in corporate tax.

Qualities of a good tax system (the canons of taxation):

 Equity: the tax rate should be justifiable rate based on the ability of the taxpayer.
 Certainty: information about the amount of tax to be paid, when to pay it, and how to pay it
should all be informed to the taxpayer.
 Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t exceed the
tax revenue itself.
 Convenience: the tax must be levied at a convenient time, for example, after a person receives
his salary.
 Elasticity: the tax imposition and collection system must be flexible so that tax rates can be
easily changed as the person’s income changes.
 Simplicity: the tax system must be simple so that both the collectors and payers understand it
well.
Impacts of taxation

Taxes can have various direct impacts on consumers, producers, government and thus, the entire
economy.

 The main purpose of tax is to raise income for the government which can lead to higher
spending on health care and education. The impact depends on what the government spends
the money on. For example, whether it is used to fund infrastructure projects or to fund the
government’s debt repayment.
 Consumers will have less disposable income to spend after income tax has been deducted.
This is likely to lead to lower levels of spending and saving. However, if the government
spends the tax revenue in effective ways to boost demand, it shouldn’t affect the economy.
 Higher income tax reduces disposable income and can reduce the incentive to work.
Workers may be less willing to work overtime or might leave the labour market altogether.
However, there are two conflicting effects of higher tax:
 Substitution effect: higher tax leads to lower disposable income, and work
becomes relatively less attractive than leisure – workers will prefer to work less.
 Income effect: if higher tax leads to lower disposable income, then a worker may
feel the need to work longer hours to maintain his desired level of income –
workers feel the need to work longer to earn more.
 The impact of tax then depends on which effect is greater. If the substitution
effect is greater, then people will work less, but if income effect is greater, people
will work more
 Producers will have less incentive to produce if the corporate taxes are too high. Private firm
aim on making profits, and if a major chunk of their profits are eaten away by taxes, they
might not bother producing more and might decide to close shop.

Fiscal Policy

Fiscal policy is a government policy which adjusts government spending and taxation to
influence the economy. It is the budgetary policy because it manages government expenditure and
revenue. The government aims for a balanced budget and tries to achieve it using fiscal policy.

A budget is in surplus when government revenue exceeds government spending. While this is good,
the economy hasn’t reached its full potential. The government is keeping more than it is spending, and
if this surplus is very large, it can trigger a slowdown of the economy.

When there is a budget surplus, the government employs an expansionary fiscal

policy where govt. spending is increased and tax rates are cut.

A budget is in deficit, when government expenditure exceeds government revenue. This is undesirable
because if there is not enough revenue to finance the expenditure, the government will have to borrow
and then be in debt.

When there is a budget deficit, the government employs contractionary fiscal policy, where govt.
spending is cut and tax rates are increased.

Fiscal policy helps the government achieve its aim of economic growth, by being able to influence the
demand and spending in the economy. It also indirectly helps maintain price stability, via the effects
of tax and spending.
Expansionary fiscal policy will stimulate growth, employment and help increase prices.
Contractionary fiscal policy will help control inflation resulting from too much growth. But as we will
see later on, controlling inflation by reducing growth can lead to increased unemployment as output
and production falls.

Monetary Policy

The money supply is the total value of money available in an

economy at a point of time. The government can control money
supply through a variety of tools including open market operations
(buying and selling of government bonds) and changing reserve
requirements of banks. (The syllabus doesn’t require you to study these
in depth)
The interest rate is the cost of borrowing money. When a person
borrows money from a bank, he/she has to pay interest (monthly or
annually) calculated on the amount he/she borrowed. Interest is also
earned on the money deposited by individuals in a bank.
(The interest on borrowing is higher than the interest on deposits,
helping the banks make a profit).
Higher interest rates will discourage borrowing and therefore,
investments; it will also encourage people to save rather than consume (a
fall in consumption also discourage firms from investing and producing
more).
Lower interest rates will encourage borrowing and investments, and
encourage people to consume rather than save (a rise in consumption
also encourages firms to invest and produce more).
The country's monetary authority cannot directly change the general
interest rate in the economy. Instead, it changes the interest rates of
borrowing between the central bank and commercial banks, as well as
the interest on its bonds and securities. These will then influence the
interest rate provided by commercial banks on loans and deposits
to individuals and businesses.

Monetary Policy

Monetary policy is a government policy that controls the money

supply (availability and cost) in an economy to attain growth and
stability. It is usually conducted by the country’s central bank and is
usually used to maintain price stability, low unemployment and economic
growth.
Expansionary monetary policy is where the government increases
the money supply by cutting interest rates. Low-interest rates will
mean more people will resort to spending rather than saving, and
businesses will invest more as they will have to pay lower interest on
their borrowings. Thus, the higher money supply will mean more money
being circulated among the government, producers and consumers,
increasing economic activity. Economic growth and an improvement
in the balance of payments will be experienced and employment will
rise.
Contractionary monetary policy is where the government decreases
the money supply by increasing interest rates. Higher interest rates
will mean more people will resort to saving rather than spending, and
businesses will be reluctant to invest as they will have to pay high
interest on their borrowings. Thus, the lower money supply will mean
less money being circulated among the government, producers and
consumers, reducing economic activity. This helps slow down economic
growth and reduce inflation but at the cost of
possible unemployment resulting from the fall in output

Supply-side policies

Supply-side policies are microeconomic policies aimed at

increasing supply and productivity in the economy, to enable long-
term economic growth. Some of these policies include:
 Public sector investments: investments in infrastructure such as
transport and communication can greatly help the economy by
making the flow of resources quick and easy, and facilitating faster
growth.
 Improving education and vocational training: the government
can invest in education and skills training to improve the quality
and quantity of labour to increase productivity.
 Spending on health: accessible, affordable and good-quality
health services will improve the health of the population, helping
reduce the hours lost to illnesses and increasing productivity.
 Investment on housing: as more housing spaces are built, the
geographical mobility of the population will increase, helping
increase output.
 Privatization: transferring some public corporations to private
ownership will increase efficiency and increase output, as the
private sector has a profit-motive absent in the public sector.
 Income tax cuts: reducing income tax will increase people’s
willingness to work more and earn more, helping increase the
supply in the economy.
 Subsidies are financial grants made to industries that need it.
More subsidies mean more money for producers to produce more,
thereby increasing supply.
 Deregulation: removing or easing the laws and regulations
required to start and run businesses so they can operate and
produce more output with reduced costs and hassle, encouraging
investments.
 Removing trade barriers: the govt. can reduce or withdraw
import duties, quotas etc. on imports so that more resources, goods
and services may be imported to increase productivity and
efficiency in the domestic economy. It can also reduce export duties
to increase the export of resources, goods and services to other
 nations, thereby encouraging domestic firms to increase
production.
 Labour market reforms: making laws that would reduce trade
union powers would reduce business costs and increase output.
Minimum wages could be reduced or done away with to allow more
jobs to be created. Welfare payments like unemployment benefits
could be reduced so that more people would be motivated to look
for jobs rather than rely on the benefits alone to live. These will not
only increase the incentive to work but also increase the incentive
to invest.
For example, India, in the early 1990’s undertook massive privatisation,
liberalisation and deregulation measures; abolishing its heavy licensing
and red tape policies, allowing private firms to easily enter the market
and operate, and opening up its economy to foreign trade by reducing
the excessive trade tariffs and regulations. This led to a period of high
economic growth and helped India become the emerging economy it is
today.

Supply-side policies have the direct effect of increasing economic

growth as the productive capacity of the economy is realised. In doing
so, it can also create more job opportunities and help reduce
unemployment. Trade reforms will also enable to it to improve its
balance of payments.

However, the reliance on public expenditure and tax cuts mean that the
government may run large budget deficits. Deregulation and
privatisation will also reduce government intervention in the economy,
which may prompt market failure.

Economic growth is an increase in the amount of goods and

services produced per head of the population over a period of
time.
The total value of output of goods and services produced is known as
the national output. This can be calculated in three ways: using output,
income or expenditure.
GDP (Gross Domestic Product): the total market value of all final
goods and services provided within an economy by its factors of
production in a given period of time.
Nominal GDP: the value of output produced in an economy in a period
of time, measured at their current market values or prices is the nominal
GDP.
Real GDP: the value of output produced in an economy in a period of
time, measured assuming the prices are unchanged over time. This GDP,
in constant prices, provides a measure of the real output of a country.
GDP per head/capita: this measures the average output/ income per
person in an economy. Since this takes into account the population, it
provides a good measure of the living standards of an economy.
GDP per capita = GDP / Population
An increase in real GDP over time indicates economic growth as
goods and services produced have increased. It indicates that the
economy is utilizing its resources better or its productive capacity has
increased. On a PPC, economic growth will be shown by an outward shift
of the PPC, which is also called ‘potential growth’. ‘Actual growth’ occurs
when the economy moves from a point inside the PPC to a point closer to
the PPC.

This diagram shows ‘actual growth’ as the economy realizes its potential
growth. In order to experience potential economic growth, the PPC
would have to shift outwards.

Causes of economic growth

 Discovery of more natural resources: more resources mean

more the production capacity. The discovery of oil and gas reserves
have enabled a lot of economies (Norway, Saudi Arabia, Venezuela
etc.) to grow rapidly.
 Investment in new capital and infrastructure: investment in
new machinery, buildings, technology etc. has enabled firms and
economies to expand their production capacities. Investment in
modern infrastructure such as airports, roads, harbours etc. have
improved access and communication in economies, helping in
achieving quicker and more efficient production.
  Technical progress: New inventions, production processes etc.
can increase the productivity of existing resources in industries and
help boost economic growth.
 Increasing the quantity and quality of factors of production:
A larger and more productive workforce will increase GDP. More
skilled, knowledgeable and productive human resources thus help
increase economic growth. Similarly, good quality capital, use of
better natural resources, innovative entrepreneurs all aid
economic growth in the long run.
 Reallocating resources: Moving resources from less-productive
uses to more-productive uses will improve economic growth.
The benefits of economic growth:

 Greater availability of goods and services to satisfy consumer

wants and needs.
 Increased employment opportunities and incomes.
 In underdeveloped or developing economies, economic growth can
drastically improve living standards and bring people out of
poverty.
 Increased sales, profits and business opportunities.
 Rising output and demand will encourage investment in capital
goods for further production, which will help achieve long run
economic growth.
 Low and stable inflation, if growth in output matches growth in
demand.
 Increased tax revenue for government (as incomes and spending
rise) that can be invested in public goods and services.
The drawbacks of economic growth:

 Technical progress may cause capital to replace labour, causing a

rise in unemployment. This will be disastrous for highly populated
underdeveloped and developing economies, pulling more people
into poverty
 Scarce resources are used up rapidly when production
rises. Natural resources may get depleted over time.
 Increasing production can increase negative externalities such
as pollution, deforestation, health problems etc. Climate change is
a consequence of rapid global economic growth.
 If the economy produces over its productive capacity and if the
growth in demand outstrips the growth in output, economic
growth may cause inflation
 Economic growth has also been accused of widening income
inequalities in developing economies, because rich investors and
businessmen gain more than the working class and poor during
growth – the benefits of growth are not evenly distributed. This will
cause relative poverty to rise.
Governments aim for sustainable economic growth which refers to a
rate of growth which can be maintained without creating significant
economic problems for future generations, such as depletion of resources
and a degraded natural environment.

Recession
Recession is the phase where there is negative economic growth, that
is real GDP is falling. This usually happens after there is rapid economic
growth. High inflation during the boom period will cause consumer
spending to fall and cause this downturn. Workers will demand more
wages as the cost of living increases, and the price of raw materials will
also rise, leading to firms cutting down production and laying off
workers. Unemployment starts to rise and incomes fall.
Causes of recession:
 Financial crises: if banks have a shortage of liquidity, they reduce
lending and this reduces investment.
 Rise in interest rates: increases the cost of borrowing and
reduces demand.
 Fall in real wages: usually caused when wages do not increase in
line with inflation leading to falling incomes and demand.
 Fall in consumer/business confidence: reduces both supply and
demand.
 Cut in govt. spending: when government cuts spending, demand
falls.
 Trade wars: uncertainty in markets, and thus businesses will be
reluctant to invest during a trade war, causing supply to fall.
 Supply-side shocks: e.g. rise in oil prices cause inflation and
lower purchasing power.
 Black swan events: black swan events are unexpected events that
are very hard to predict. For example, the COVID-19 pandemic in
2020 which disrupted travel, supply chains and normal business
activity, as well as consumer demand, has caused recessions in
many countries.

Consequences of recession:
 Firms go out of business: as demand falls, firms will be forced to
either reduce production to a level that is sustainable or close shop.
 Unemployment: cuts in production will cause a lot of people to
lose work.
 Fall in income: cuts in production also causes a fall in incomes.
 Rise in poverty and inequality: unemployment and lack of
income will pull a lot of people into poverty, and increase inequality
(as the rich will still find ways to earn).
 Fall in asset prices (e.g. fall in house prices/stock market):
recessions trigger a crash in the stock markets and other asset
markets as investors’ and consumers’ confidence in the well-being
fall of the economy during a recession. The shares owned by
investors will be worth less.
  Higher budget deficit: due to falling consumption and incomes,
the government will see a fall in tax revenue, causing a budget
deficit to grow.
 Permanently lost output: as firms go out of business and
employment falls, it results in a permanent loss of output, as the
economy moves inwards from its PPC.

If the economy
was producing at A on its PPC, a recession will cause production to
fall to B.

Policies to promote economic growth

Expansionary fiscal and monetary policies (demand-side policies)
and supply-side policies described in the previous sections can be
employed to promote economic growth, depending on the nature of the
problems that are holding back the economy from growing. For example,
if it is the poor quality of human capital (labour) that is preventing the
economy from achieving its maximum productive capacity, the
government should invest in education and vocational training centres to
improve the quality of the labour force and increase productivity. If it is a
lack of effective demand causing slow growth, the government should
focus on cutting income taxes, indirect taxes and interest rates to boost
spending.

Effectiveness of such policies:

 Demand-side policies that increase the rate of growth above the

long-run trend rate will cause inflation and quickly lead to a
recession if not controlled.
 Supply-side policies can take considerable time to take effect.
For example, if the government invested in better education and
 training, it could take several years for this to lead to higher labour
productivity.
 In a recession, supply-side policies won’t solve the fundamental
problem of deficiency of aggregate demand. Increasing the
flexibility of labour markets and encouraging investment may help
to some extent, but unless there is sufficient demand, firms will be
reluctant to increase production and make new investments.